Greece Risks Meltdown After Bailout Vote Bombshell

A high-risk gamble by the Greek government may threaten Greece's financial survival and the cohesion of the euro zone.

Greek Prime Minister George Papandreou announced unexpectedly on Monday that he would hold a public vote on Europe's latest policy prescriptions for Greece, which if enacted would allow the country to avoid default and remain in the euro zone. Many European leaders and investors were aghast at the gamble, which some economists say increases the likelihood that Greece will default after all, abandoning the euro in the process.

Such an outcome would consequently put Spain and Italy in danger of default and Europe at risk of a bank run.

"If they [the Greeks] vote no, then we are back to square one," said Diego Iscaro, senior European economist at IHS Global Insight. "Greece will be without a deal and without a government."

Stock markets around the world tumbled in response to Papandreou's decision, since it called into question the finality of Europe's decision last week to give Greece more bailout money and to force banks to write down 50 percent of Greece's debt. The S&P 500 plunged 2.79 percent, the German DAX fell 5.00 percent and the French CAC 40 plummeted 5.38 percent on Tuesday. The euro also fell 1 percent against the dollar.

Meanwhile, the borrowing costs of larger troubled countries, such as Spain and Italy, spiked as investors grew more fearful that those countries could default on part of their debt. Interest rates for Italian sovereign debt reached a record high on Tuesday, according to the Financial Times.

The Greek Parliament will hold a vote of confidence on the current government this Friday and it is unclear whether the majority Socialist party will prevail. One Socialist party member already has defected and six others asked for Papandreou to resign and schedule early elections for a new "politically legitimate" administration.

Some economists said that Greece's decision to hold a referendum has substantially raised the possibility that the government could fall and that Greece could be forced to default and abandon the euro if it stops receiving bailouts from Europe. They said that even if the Greek government survives Friday's no-confidence vote, it still could face an uphill battle in winning the referendum. More than half of Greeks have said that they oppose the austerity measures that Europe has forced on Greece, although a majority also have said that they support keeping the euro.

NYU economist Nicholas Economides said that if the government loses the referendum, it would effectively become powerless and the administration would likely have to resign. He said this would put "tremendous pressure" on Italy and Spain, since their borrowing costs would spike and they would face the same situation that Greece encountered in early 2010.

"The European Union has missed the opportunity to get rid of the Greek problem once and for all by putting some money there in making Greece an isolated case," Economides said. "Right now the EU has to face the consequences in all the other weak countries."

If a new Greek government were to come to power and ask to renegotiate the bailout agreement, then top European leaders "would cut off the plug, cut Greece adrift, and we would have a downward-lurching economy," said Jan Randolph, head of sovereign risk at IHS Global Insight.

The higher likelihood of a Greek default now also raises the possibility that sovereign debt in Spain and Italy will need to be restructured in order to prevent default there, said Jay Bryson, global economist at Wells Fargo.

"It's too late to isolate Greece," Bryson said. "The contagion has already spread."

Some experts said that the financial problems in other troubled countries will not be any easier to solve than the debt issues in Greece, where thousands have flooded the streets to protest austerity measures. Joshua Rosner, managing director at the research consulting firm Graham Fisher & Co., said that since Europe has opened the "Pandora's box" of haircuts on Greek sovereign debt, now political oppositions in Italy, Spain, Portugal, and Ireland "will be asking for their fair share," resulting in a stalemate in international negotiations driven by each country's domestic discord.

Some economists said that the center of the drama now is in Italy, where European leaders are hoping to force the Italian government to implement structural economic reforms, but Prime Minister Silvio Berlusconi faces stiff opposition. Iscaro said that the Italian government perhaps can finance itself for another year with higher interest rates, until it faces the danger of becoming insolvent like Greece.

Randolph said that European leaders deliberately are allowing interest rates on Italian debt to rise in order to force the Italian government to implement structural reforms, which may not happen as long as Berlusconi, who has lost his political capital, stays in power.

"It's a high-risk game," Randolph said. "Whatever happens to the euro and the European economy will focus very intensely on Italy."